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The Forgotten “Flash Crash” – One Year LaterGary Dorsch One year ago, few traders were expecting a pullback of any significant degree, with the Dow Jones Industrials perched above the 11,000-level. Traders had become complacent after a year long advance, in which the Dow Industrials had risen +70% above its bear market low, while retreating only twice for minor pullbacks. Traders stopped thinking about potential dangers, and started believing the risk of another bear market had vanished. Yet simmering beneath the surface was the specter of a sovereign debt default, rivaling the size of Lehman Brothers’, and threatening the world economy with a “double-dip” recession. The May 6th, 2010 “Flash Crash,” carries the distinction for the second largest point swing, 1,010-points, and the biggest one-day point decline, of 998.5-points, on an intraday basis in the 114-year history of the Dow Jones Industrial Average. Crashes can occur during bear or bull markets, and are characterized by panic selling and abrupt, dramatic price declines. Whereas the average time for a decline in the S&P-500 to reach the threshold of a bear market is about nine months, a Crash can reach bear market territory in a matter of days. A Crash is often the result of unanticipated catastrophic events, such as fears of a meltdown of Japan’s nuclear reactors, a sudden banking crisis, or the collapse of a stretched speculative bubble. However, in many cases, the warning signals of danger that precede a stock market Crash are flashing brightly for days, weeks, or months, yet the danger signals are either ignored or incorrectly interpreted by market bulls. “A trend in motion, will stay in motion, until some major outside force, knocks the market off its upward course.”
Regulators say a large seller of E-Mini futures and a large purchase of put options on the S&P-500 Index by a hedge fund set off a chain of events that triggered the “Flash Crash.” High frequency traders sold aggressively to liquidate their positions and quickly withdrew from the markets to avoid the meltdown, once the Crash began. The combined actions of these events sent the Dow Jones Industrials plunging -7% in just 15-minutes. Yet for seven days, prior to the historic “Flash Crash,” bullish equity traders had plenty of time to exit from over-extended long positions, but didn’t, because the small and obscure credit default swap market for Greece’s debt, wasn’t even on their radar screens. The Greek, Irish, and Portuguese bond markets were seriously breaking down for several months preceding the May 6th “Flash Crash” on Wall Street. Prices of government bonds of all three countries continued to fall and interest rates rose sharply, while the cost of insuring their debt from the chance of default rose even more dramatically. The credit default swap (CDS) market is a hotbed of speculation, where banks and hedge funds, can bet on the odds of a country or company defaulting on its debts, without holding the underlying bonds. In the weeks preceding the May 6th “Flash Crash, the cost of insuring Greece’s debt against the possibility of default, had tripled, from around $410,000 to insure $10-million of debt, to as high as $1.2-million. The threat of a sovereign default, most immediately by Greece, but also by Ireland and Portugal, provided an opportunity for speculators to drive up the price of their CDS rates, while at the same time, profiting by short selling the Euro. Just a year ago, there was increasing speculation that the 11-year-old Euro currency would break apart under the pressure of a financial crisis, if Greece defaulted on its 330-billion Euros of debt. Analysts were no longer discounting the possibility that a delinquent debtor, such as Greece, could be pushed out of the monetary union. Reflecting the scope of these concerns, investors began shedding positions in Club-Med bonds, and swapped the proceeds into US Treasuries and Japanese yen, both seen as temporary safe havens.
For five months, prior to the “Flash Crash”, the Euro’s exchange rate versus the US-dollar was tumbling from around $1.500 in November 2009, to as low as $1.3200 by late April 2010. At the same time, the cost of insuring $10-million of Greek government bonds, against the chance of a default or restructuring was steadily climbing upwards. The newly installed Greek government dropped a bombshell, when it admitted that the country’s public debt was far greater than previously reported, at 112.5% of GDP, and was projected to hit 135% by 2011. The S&P debt rating agency moved quickly to lower Greece’s rating from A- to BBB+, and warned of further reductions, if Athens, “is unable to gain sufficient political support to implement a credible medium-term fiscal consolidation program.” In the currency markets, the Euro began to slide, as yields on Greek, Irish, Portuguese, and Spanish bonds began to climb sharply higher. Attracted to the highly indebted Greek bond market like vultures to a decaying corpse, the CDS traders at major banks and hedge funds moved in for the kill. “Too big to fail” banks were able to return to the gambling tables fully aware that their losses would be covered in future by taxpayers, despite their involvement in the most hazardous forms of speculation. But there were also legitimate hedging activities in the CDS market, since French banks held $75-billion worth of Greek debt, Swiss banks with $64-billion, and German banks with $43.2 billion. The US-stock market’s rally from the March 2009 lows was perhaps, the most non-believed rally in history. But the bears got a sense of vindication by the “Flash Crash,” which at the time, was interpreted in many circles as a watershed event, signaling the end of the cyclical bull market that began 14-months earlier. This time, the culprit was a spike in Greece’s bond yields, and its soaring credit default swap rates, and heightened worries that Athens might default on more than $300-billion of debt. The overall amount of insurance on Greece’s debt hit $85-billion in February 2010. One year earlier, the same figure stood at $38-billion.
On April 27th, 2010, the S&P rating agency pushed Greece to the brink of the financial abyss and downgraded Portugal’s debt to A-, fueling fears of a continent-wide debt meltdown in Europe. Stocks around the world tanked when Greek bonds were lowered to junk status, at BB+. Greece’s financial contagion began spreading to Portugal and Ireland. European stock exchanges fell 2.5%, and the Dow Jones Industrial fell more than 200-points. Greek and Portuguese stock indexes were especially hard hit, falling -6.7% and -5.4%, respectively. The Euro continued to spiral lower, briefly skidding below $1.200 in June 2010, until China’s political leaders signaled their support for the common bloc currency. Two-weeks before the “Flash Crash” unfolded, Germany’s finance minister Wolfgang Schauble warned that a failure to rescue Athens would risk a financial meltdown. “We cannot allow the bankruptcy of a Euro member state like Greece to turn into a second Lehman Brothers,” he told Der Spiegel. “Greece’s debts are all in Euros, but it isn’t clear who holds how much of those debts. The consequences of a national bankruptcy would be incalculable. Greece is just as systemically important as a major bank,” he warned. However, traders on Wall Street weren’t fazed by Schauble’s warnings, reckoning that at the end of the day, the wealthy Euro-zone nations would be opt for a bailout, of their delinquent neighbors. Yet the fallout from the “Flash Crash” would lead to a -14% correction for the Dow Industrials, the only meaningful setback during its cyclical Bull rally. It seemed as if, the old adage, “Sell in May, and go Away” was still a valid tidbit of advice. When the Dow Industrials slumped to below the psychological 10,000-level, there were renewed fears over what bad debts lurked on the balance sheets of Europe’s banks, that could paralyze lending and trigger a “double-dip” recession in the Euro-zone. Stock market bulls lost their swagger, even after EU finance ministers agreed to fund a €750-billion ($1-trillion) bailout fund for delinquents, and to prevent the Euro currency from tearing apart and derailing the global economic recovery. To read the rest of this article, please click on the hyper-link below: http://www.sirchartsalot.com/article.php?id=152 ### May 2, 2011 321gold Ltd |
